The United Nations (UN)’ Handbook on Extractives Industries Taxation identified important tax issues in the extractive industries, including the indirect transfer of assets, permanent establishment issues and transfer mispricing risks. However, the handbook fell short of addressing how beneficial ownership and project-level reporting disclosure can help address concerns on these topics. This blog is the second in a two-part series, you can read part one “Why the EITI does not stop at recommending contract transparency”[1] on EITI.org.

Contract transparency is vitally important to ensuring effective and accountable tax regimes. The latest UN’ handbook recognises that the EITI can facilitate public access to extractive industries contracts. The UN’s handbook, however, doesn’t reveal the extent to which EITI data has led to enhanced domestic resource mobilisation.

The handbook states that “the information and knowledge needed to design and administer appropriate tax rules that apply to the extractive industries may be lacking or very thinly spread locally.” By making beneficial ownership data publicly available and requiring project level reporting, EITI data will help under-resourced tax administrations that are not well equipped to deal with complex tax avoidance scenarios.

Outlining the challenge

Using beneficial ownership data to tackle capital gains tax avoidance

In most cases, governments are interested in taxing capital gains derived from the indirect transfer of shares/assets. The handbook defines an indirect transfer of assets in the extractive industries field as “instead of transferring an asset (e.g. a mine itself (direct transfer) the owner (often resident offshore) of an entity holding the asset may transfer its interest in that entity – thus indirectly – transferring the underlying asset.” In many cases these transactions are done to avoid capital gains tax by having the transfer occur at the company level rather than transferring the assets which – most of the time – are located in higher-tax jurisdictions (see the Freeport McMoRan transaction in the Democratic Republic of Congo). As a result, governments spend significant resources trying to ensure that capital gains taxes are paid.

There are several challenges facing tax authorities when dealing with these scenarios. This blog will focus on the lack of information available to the government to follow up on inconsistencies in ownership after an indirect transfer of assets occurs. To ensure that indirect transfers of assets are properly taxed, administrators need to have information on the individuals or legal entities that exercise influence or control over the project.

The UN Handbook states that “a particular issue for many policymakers and administrators is how a policy decision to tax indirect transfer can be effectively implemented in practice” considering, for example, that the transferee and transferor could be foreign entities and hence harder to identify/administer/tax by the host Tax Administration (where the extractive project is located). According to the handbook, “keeping track of changes in the indirect ownership of assets imposes an increased burden on tax administrations and can be constrained by its ability to collect and compile information.” […] “The more capable the information technology systems of an administration are; the more effective its information-gathering powers are; and the more integrated into the international system of exchange of taxpayer information it is, the easier it will be to account for and tax indirect transfer of assets.”

While the handbook recognizes lack of information as a challenge, it does not explain what type of information is needed to tackle capital gains tax avoidance. Moreover, it does not highlight what information is currently available or will be made available in the short to medium term, such as beneficial ownership disclosure. In most countries, beneficial ownership legislation requests companies to submit a self-declared Informative Affidavit of Final Beneficiary, but it is usually tax administrations that validate the reported information.

The VII Regional Meeting on International Taxation revealed weak information exchange processes as a key challenge for Latin American and Caribbean tax authorities when implementing international tax frameworks. Specifically, the need for “processes or mechanisms that make use of information exchange to validate self-declared information.” In the case of countries with a weak network of information exchange, having reliable beneficial ownership data made public is vital. It also means data verification can be done by civil society and citizens.

With the adoption of the beneficial ownership (BO) requirement in the EITI Standard, by 2020, implementing countries have to ensure that all oil, gas and mining companies that bid for, operate or invest in extractive projects in the country disclose their beneficial owners. In addition. politically exposed persons holding ownership rights must be identified. The EITI recommends that beneficial ownership information is made available through public registers. At a minimum, the information must be included in the country’s EITI Report.

For example, Zambia’s EITI Report recommends “making progress on implementation of beneficial ownership disclosure, and to ensure that ZEITI’s efforts to disclose beneficial ownership data is linked to ongoing efforts within the government to address key challenges in the extractive sector such as tax evasion and transfer pricing.”

Using project-level reporting to tackle transfer mispricing and permanent establishment issues

Ring fencing is a “limitation on consolidation of income and deductions for tax purposes across different activities, or different projects, undertaken by the same taxpayer.” Governments can decide to ring fence tax obligations by activity or individual contract areas/mining projects. There is the possibility of corporate income tax (CIT) and royalties being ring fenced differently depending on the government’s tax policy. In the case of CIT, many governments decide not to ring-fence reporting per mine or oil project as the taxation happens for companies as a whole. Notably, the Liberian EITI validation report draws attention to an exception in Liberian legislation, which requires corporate income taxes by individual project “to curb basic forms of transfer mispricing.” However, in most cases, only royalties are paid by oil field/contractual area.

• The handbook describes several examples of transfer pricing issues that arise in the extractive industries. When a country’s legal framework requires ring-fenced tax obligations per projects, project-level reporting can help illuminate transfer mispricing practices. Transfer mispricing risks related to royalties are high, given that their calculation is based on revenues.

  For example, when a company has more than one project and the government grants a tax holiday to a single mining project (often creating free trade zones), project-level reporting disclosures can help mitigate the risks of costs being transferred between mines that have the same ownership.

• In general, oil companies sign a contract with the government agency to explore and operate a block/field. The handbook examines the concept of permanent establishment (PE) in the oil and gas sector in detail. For the host country (where the block/field is located), the implications of recognising the presence of a PE is relevant when a tax treaty is in force. Article 7 (1) of the UN Model Convention stipulates that the business profits of a foreign enterprise are taxable in a State only if the enterprise has a PE to which the profits are attributable in the State. Hence, for tax authorities, the definition of a PE will be critical.

  The handbook anticipates that every contractual area can be considered an independent PE. Here the concept of ring fencing becomes important. If ring fence regulations apply under domestic law, the investor won’t be able to offset profits and losses from different contractual areas (or PEs). Considering that “interpreting what exactly constitutes a permanent establishment in a particular location is very much a grey area,” project by project level reporting becomes highly relevant. This will be useful to analyse the existence of a PE in the host country.

EITI countries reporting on the fiscal years ending on or after 31 December 2018 must disaggregate revenue streams by individual projects.

Next steps

Comprehensive disclosures of production and export values and volumes, as well as government revenues from the extractive sector, project-level reporting and beneficial ownership disclosures will support the efforts of tax administrations and civil society to understand the main tax avoidance risks. Transparency and accountability as a tool to improve tax collection and domestic resource mobilization should be take into account by the time the UN Handbook will next be updated.

Currently, Peru, Colombia, Mexico, Dominican Republic, Honduras, Guatemala, Trinidad and Tobago, Suriname and Guyana are EITI countries. Argentina and Ecuador already presented their intentions to join the EITI.

[1] The first part of this blog identified how production/export volumes and values, and taxes and government revenues already disclosed through EITI Reports in EITI countries could be useful to analyse risks to the tax base in the extractive industry value chain by Tax authorities and civil society.

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